RESEARCH CASE 2
RESEARCH CASE 2
(a) FASB pronouncements usually provoke some controversy, and Concepts Statements are no exception. The principle objections raised in recent Exposure Drafts are largely the same objections raised when the Board was deliberating Concepts Statement 7. They focus on three areas:
1. Use of the expected-cash-flow approach in developing present value measurements
2. Use of fair value as the objective for measurements on initial recognition and subsequent fresh-start measurements that employ present value.
3. Inclusion of the entity’s credit standing in the measurement of its liabilities.
(b) Prior to Concepts Statement 7, many accounting pronouncements used the term best estimate to describe the target for estimated cash flows. The term was never defined, but its contexts seem to suggest that an accounting best estimate is:
1. Unbiased
2. In a range of possible outcomes, the most likely amount
3. A single amount or point estimate.
RESEARCH CASE 2 (Continued) Few other professions follow the accounting practice of equating best
estimate and most likely. Statisticians, actuaries, scientists and engineers tend to avoid the term best estimate. When they use it, they do so to describe the expected value—the probability-weighted average. But accountants have grown used to the most-likely meaning for best estimate.
The Board has long recognized that present values can be changed by altering either cash flows or discount rates. Still, the Board’s early deliberations took the traditional path of developing a best estimate of cash flows and then selecting an appropriate interest rate. Over time, the Board found that a focus on finding the “right” interest rate was unproductive. Any positive interest rate would make the discounted number smaller than the undiscounted best estimate, but there had to
be more to present value than that. Moreover, it became clear that intuitions built on contractual cash flows and interest rates don’t always work when applied to assets and liabilities that don’t have contractual amounts and payment dates.
Moving the reference point from contractual to estimated cash flows disrupts the conventional relationships that apply to contractual cash flows. What is the “rate commensurate with the risk” when actual cash flows may be higher or lower than the best estimate? Is the rate higher or lower than risk free? By how much? Does the answer change if the item is a liability rather than an asset? What are the proper cash flows and interest rate when timing is uncertain? The traditional approach doesn’t provide ready answers to those questions. In a sense, the drafters of Opinion 21 had it right. If a single best-estimate of future cash flows and a single interest rate are the only tools for computing present value, then the technique cannot reasonably by applied to a broader range of measurement problems.
RESEARCH CASE 2 (Continued) (c) The Board was looking at two sets of principles: the elements of
economic value and the practical principles of present value. The elements of economic value (paragraphs 23 and 39) are:
a. An estimate of the future cash flow, or in more complex cases, series of future cash flows at different times
b. Expectations about possible variations in the amount or timing of those cash flows
c. The time value of money, represented by the risk-free rate of interest
d. The price for bearing the uncertainty inherent in the asset or liability
e. Other, sometimes unidentifiable, factors including illiquidity and market imperfections.
The practical principles, stated simply, are:
a. Don’t leave anything out. (But see item e.)
b. Use consistent assumptions and don’t count the same thing twice.
c. Keep your finger off the scale.
d. Aim for the average of a range, rather than a single most-likely, minimum or maximum amount.
e. Don’t make up what you don’t know. (d) Most accounting estimates use nominal amounts; the estimate
includes the effect of inflation. The focus here is on Practical Principle (b)—Use consistent assumptions. If the estimated cash flows do not include inflation, if instead they are real amounts, then the discount rate should not include inflation. Nominal cash flows are discounted at a nominal rate, and real cash flows at a real rate.